United States Court of Appeals For the Ninth Circuit

< No. 9824

In the United States Circuit Court of Appeals
for the Ninth Circuit

Vv.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

4
ON PETITION FOR REVIEW OF TIE DECISION OF THE UNITED
4 STATES BOARD OF TAX APPEALS

BRIEF FOR THE RESPONDENT

—

SAMUEL O. CLARK, Jr.,
Assistant Attorney General.
HELEN R. CARLOSS,
SHERLEY EWING,
Special Assistants to the Attorney General.

Page
eee CLO Ne ee che een. 1
Jurisdiction. ---------------- 00. 1
Questions presented_---------------- 2
Statute and regulations involved_--------------- »
Statement__----------------------------------------- eee 2
Seatmrry Ol agement a= = een. 52-2 ee A
Argument:
I. The taxpayer was not entitled to an exemption under Section
d(C ee ie ie See ee 5
Il. The taxpayer was not entitled to either of the credits granted
in Section 26m nly or 26 (¢c) (2)..-..--------225--2+-.- 10
(Conclusion. _- 2= == in Set So. oe ee eee i133
ESSE S106 TE IRR Ss ee ee eas nen 14-18
CITATIONS
Cases:
Bastian Bros. Co. v. McGowan, 113 F. (2d) 489, certiorari

oertyrol, BU WW, Si. OP sess ae rear res 11
Eire COMIMMSSLONCMOOMER (20) (Otaa-s2-eeoe ean ee oes ae 6
Central West Public Service Co v. Craig, 70 F. (2d) 427____----- 6
Cincinnati Equipment Co. v. Degnan, 184 Fed. 834--_---------- 8
Gayman v. Publishing Co., 167 Md. 275 ......-.2...---.-.-- 9
Commerce Trust Co. v. Woodbury, 77 F. (2d) 478, certiorari denied,

AOU Soni ke eee ek ek Ee 6
Cooperative Pub. Co. v. Commissioner, 115 F. (2d) 1017.____---- WO} Tah
Crane-Johnson Co. v. Commissioner, 105 F. (2d) 740, affirmed,

RE Pe den eee Se eee ee rece be Se ske 10
Wereper vo right, 94 U. 8558.. 22 ee 8
Elmhurst Cemetery Co. v. Commissioner, 300 U. S. 37, reversing

gm) A er es Bly ie 2 fas ee Se ee ee 6
Fesler v. Commissioner, 38 F. (2d) 155, certiorari denied, 281

1, iS, PSG pees 2 = ele yO ap 6
Helvering v. Inter-Mountain Insurance Co., 294 U.S. 686____._- 10
Helvering v. Northwest Steel Mills, 311 U. 8S. 46_________- LO Moras
Long v. Republic Varnish Enamel &c., Co., 115 N. J. Eq. 212. ~~ 9
Oak Woods Cemetery Ass’n v. Commissioner, 111 F. (2d) 863,

ccmmorart dened, 308 U.S. G16..... 2.5.2... 22565-5.40cu5 6
United Staies v. Anderson Co., 119 F. (2d) 343_.........-..-.-- 6, 7,9
Wigiiiote Co. vy. Hinckley, 115 F. (2d) 920...-_....._-....2.... 11

Statute:
Revenue Act of 1936, c. 690, 49 Stat. 1648:
SCCM Were. SoS hs Ce eee a ee ee 14
eC MONe LUM cw oa e ine = ee eee eee ee 14

4095538—41——1 (1)

il

Miscellaneous: Page
H. Rep. No. 2475, 74th Cong., 2d Sess., p. 4 (1939-1 Cum. Bull.
CRarcs 2 hOGA 5009) < .oeere. 2 2 Sere ers ee ee 9
S. Rep. No. 2156, 74th Cong., 2d Sess., p. 14 (1939-1 Cum. Bull.
(Part; 2)%6 7,8) eee ee ee mney ec. Dy ee ee 10
Treasury Regulations 94:
Article: [4 Geta eae ne, eS ao, ee ee ee NS
Article: 26-2 90 aeee = 2 so) stare zc Es ee ee ee 16

In the United States Circuit Court of Appeals
for the Ninth Circuit

No. 9824

ARTESIAN WATER COMPANY, A CORPORATION, ceTTTIONER
v.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

ON PETITION FOR REVIEW OF THE DECISION OF THE UNITED
STATES BOARD OF TAX APPEALS

BRIEF FOR THE RESPONDENT
OPINION BELOW

The opinion of the United States Board of Tax
Appeals (R. 21-37) is reported at 43 B. T. A. 408.

JURISDICTION

This case involves deficiencies in income taxes in the
calendar year 1937 in the amount of $7,380.33. (R.
38.) The order of the Board was entered January 24,
1941 (R. 37-88), and the taxpayer filed a petition for
review on April 16, 1941 (R. 38-41), in accordance
with the provisions of Sections 1141 and 1142 of the
Internal Revenue Code.

(1)

2

QUESTIONS PRESENTED

The questions presented to this Court are:

1. Whether the taxpayer is entitled to an exemption
from the undistributed profits tax by virtue of Section
14 (d) (2) of the Revenue Act of 1936; or

2. If not falling within the exemption, whether the
taxpayer is entitled to a credit under either Section
26 (c) (1) or Section AOE) 2).

STATUTE AND REGULATIONS INVOLVED

The statute and regulations involved are set forth in
the Appendix, fra, pp. 14-18.

STATEMENT

On November 12, 1929, the taxpayer, a California
corporation (R. 23), refinanced a loan owing to the
Pacific Mutual Life Insurance Company, executing a 6
percent promissory note for $175,000 due November 12,
1934. Subsequently another similar note was executed
for $35,000. (R. 24, 54-55, 59-60.) Both notes were
secured by a mortgage on unimproved farm lands (R.
24, 58), the mortgage providing that it should secure
any subsequent loans (R. 68). The original note was
further secured by an assignment of a lease of certain
oil properties which the Shell Oil Company leased from
the taxpayer. However, all royalties from the lease
were paid by Shell Oil directly to the taxpayer. A
separate agreement was made concerning the $35,000
note to the effect the taxpayer would refrain from de-
claring any dividends while the note was unpaid. (R.
24-25.) The mortgage covered substantially the ma-
jor portion of the company’s assets, while the lease to

3

Shell Oil yielded over 90 per cent of the income. (CR.
23, 24, 77.)

In July, 1935, the taxpayer was placed in receiver-
ship under the California law. The receiver was
appointed as a result of a petition filed by a Judgment
erveditor of one of taxpayer’s stockholders. The judg-
ment creditor, having acquired stock of the taxpayer at
a sheriff’s sale, applied to the corporate officers of the
taxpayer to transfer the stock to him on the company’s
books. Upon the refusal of the officers to do so, the
judgment creditor petitioned for the appointment of a
receiver on the ground that the company’s officers were
not functioning under California law. The receiver-
ship had no connection with taxpayer’s ability or dis-
ability to pay its debts, nor did the Pacific Mutual have
anything to do with it. The taxpayer owed no debts
other than current obligations which were paid when
due. (R. 25-27.)

Sometime around the middle of the year 1936 a con-
servator was appointed for the Pacific Mutual and the
loans to the taxpayer came under close scrutiny and
severe criticism, because of certain interlocking
interests between the two companies. (R. 46, 78.)

Nothing was paid on the principal of this obligation
until late in 1936. In September of that year an agree-
ment was reached between the receiver and the con-
servator whereby the time for payment of the loan was
extended to March 2, 1937, conditioned upon certain
payments being made during the ensuing period. This
agreement was evidenced by an exchange of letters.
(ht. 27, 83.) During 1936 the receiver paid $25,000 on

4

the notes and made additional payments during 1937,
reducing the total balance due to $100,250. The smaller
note was paid off in full during 1937 and the larger one
nol [ere Es, ll, Se, )

The taxpayer had net income of $54,101 during 1937
on which it paid the normal tax. (R. 33, 113.) This
ease involves the deficiency asserted by the Commis-
sioner of Internal Revenue in the surtax for the year
1937.

The Commissioner, in his deficiency notice, stated
that the taxpayer was not, under the facts presented,
entitled to an exemption. A credit of $8,250 represent-
ing the amount paid during 1987 on the $35,000 note was
allowed as a credit for contracts restricting dividends.’
The amounts paid on the $175,000 note were not allowed.
The Board upheld the Commissioner. (R. 22-23.)

SUMMARY OF ARGUMENT

The Board’s finding that the taxpayer was not insol-
vent is supported by substantial evidence and therefore
is conclusive on this Court. Hence, it is not entitled
to the exemption from the surtax provided in Section
14 (d) (2). The execution of promissory notes, secured
by a mortgage on most of taxpayer’s assets and by the
assignment of a lease constituting the principal source
of taxpayer’s income, does not constitute a written con-
tract expressly dealing with the payment of dividends
nor a written contract expressly dealing with the dis-
position of earnings and profits, within the meaning of

* There is no reference in this record to the contract upon which

this credit was based. However, the amount of the credit granted
is not in issue.

9)
Section 26 (c) (1) and 26 (c) (2). Hence the corpora-

tion is not entitled to a credit under either of those
provisions.
ARGUMENT

iL

The taxpayer was not entitled to an exemption under section
14 (d) (2)

Section 14 of the Revenue Act of 1936 imposed a
surtax on corporate profits, earned but not distributed
during the tax year. Section 14 (d) (2) provided an
exemption for corporations in bankruptey or msolvent
and in receivership. Section 26 (¢) (1) granted a
eredit for undistributed profits that could not be dis-
tributed during the taxable year as dividends “without
violating a provision of a written contract executed by
the corporation prior to May 1, 1936, which provision
expressly deals with the payment of dividends.’’ Simi-
larly, Section 26 (¢) (2) granted a eredit for undistrib-
uted earnings and profits which were required to be
paid or irrevocably set aside within the taxable year
for the discharge of a debt by ‘‘a provision of a written
contract executed by the corporation prior to May 1,
1936, which provision expressly deals with the dispo-
sition of earnings and profits for the taxable year.”’

The first. question to be resolved is whether this tax-
payer was entitled to an exemption under Section
14 (d) (2). We may concede, for the purposes of this
part of the argument, that it is enough if the corpora-
tion is insolvent and in receivership and the nature of
the receivership proceeding is immaterial. However,

6

the Commissioner and the Board must determine
whether the taxpayer was insolvent. Such a determi-
nation is essentially a finding of fact which, if sup-
ported by substantial evidence, is conclusive. Llinharst
Cemetery Co. v. Commissioner, 300 U. S. 87, revers-
ing 83 F. (2d) 4 (C. C. A. 7th) ; Oak Woods Cemetery
Ass’n. v. Commissioner, 111 F. (2d) 863 (C. C. A. 7th),
certiorari denied, 308 U.S. 616. Of course, if there is
no evidence to support the Board’s finding, this Court
would be entitled to reverse. Cf. United States v. An-
derson Co., 119 F. (2d) 348 (C. C. A. 7th) ; Commerce
Trust Co. v. Woodbury, TT F. (2d) 478 (C. C. A. 8th),
certiorari denied, 296 U. 8. 614; Central West Public
Service Co. v. Craig, 70 F. (2d) 427 (C. C. A. 8th).
However, the taxpayer has the burden of presenting
substantial evidence to offset the Commissioner’s de-
termination. See Kesler v. Commissioner, 38 F. (2d)
155 (C. C. A. 7th), certiorari denied, 281 U. S. 755;
Brown v. Commissioner, 22 F. (2d) T97 (C. C. A. 5th.)

It cannot seriously be contended that the taxpayer
was insolvent in a bankruptcy sense of having labil-
ities exceeding assets. The balance sheet, as filed with
the company’s income tax return for the year, showed
total assets of $1,162,798, and total] liabilities, exclusive
of capital stock and surplus, listed at $144,255. Sub-
stantially, the same situation had existed at the begin-
ning of the year. (R. 33, 113.) In the taxpayer’s
brief (p. 16) there is an attempt to discredit the Board’s
finding on the ground that the figures given above were
merely book values as of March, 1913, claiming that
the values were less in 1987, and that no depletion for

(

vil had been charged against assets on the books. The
only testimony regarding the value of the assets was
that the receiver, admittedly not a real estate man,
who ‘‘wouldn’t know” but ‘‘would say’’ that there
would be a substantial difference in such values. (R.
100.) The testimony regarding depletion was to the
effect that if the undivided profits at the end of the
year of $34,442 had been reduced by the claimed de-
pletion of $44,863, there would be no undivided profits
balance but a deficit of approximately $10,400. Ad-
mitting the mathematical accuracy of this calculation,
it is submitted that it has no effect on the present issue.
A deduction from undivided profits would not affect
the balance between assets and liabilities, exclusive of
eapital stock and surplus. Clearly, there is no evidence
here which the Board would have been justified in
using to offset the balance sheet figures. Nor is there
any evidence in the record to warrant a finding that
the assets were overvalued on the company’s books by
something over a million dollars which would be the
adjustment necessary to make liabilities exceed assets.
Therefore, the principal question under the exemp-
tion section is whether the taxpayer was insolvent in the
so-called equity sense—that is, was it unable to meet its
currently maturing obligations. The problem was
well posed in United States v. Anderson Co., supra,

where the court said (p. 345):
The practical question is—Under what cir-
cumstances may a court say that a corporation

is unable to pay its debts as they fall due in the

usual course of trade or business ?
409538—4 1 —_2

8

It will be noted that in defining insolvency the authori-
ties stress the fact that it means inability to pay debts
as they become due in the ordinary course of business.
See Dutcher v. Wright, 94 U.S. 553; and Cinecinnats
Equipment Co. v. Degnan, 184 Fed. 834 (C. C. A. 6th).
The record in this case shows that all debts of this com-
pany were paid except the obligation owed to the Pacific
Mutual (R. 97), which debt originally fell due in No-
vember, 1934. The record is somewhat indefinite with
regard to what steps, if any, were taken to secure an
extension or to refinance the debt from the due date
until 1936. It may be that originally a request for an
extension was refused (R. 84) but insofar as there is
any substantial evidence in this record it is evident that
the negotiations were not seriously undertaken until
1936, although the receiver had been appointed in July,
1985. (R. 77.) At no time did the taxpayer become
involved in any legal proceedings because of its in-
ability to pay its bills. (R.97.) Nothing was paid on
the principal of this obligation from the time the loan
was made until late in the year 1936. (R. 85.) It
was around the middle of 1986 that a conservator had
been appointed for the insurance company (R. 46, 78)
and it would appear that it was only after that time
that the ereditor began to be really concerned about the
liquidation of the loan (R. 78). There is certainly sub-
stantial evidence to support a finding that this obhga-
tion was not ‘“‘currently maturing.’? Since the debt
had originally become due in 1954 and the creditor took
no steps for its collection other than to grant an exten-
sion in September, 1936, until March, 1937, it is quite

9

apparent that the creditor was acquiescent in the in-
stallment payment of this debt. Moreover, after
March, 1937, the creditor continued to permit the debtor
to pay off the debt in installments. From these facts
it would be impossible to consider that this obligation
was one falling due in the ordinary course of business.
In effect and in reality, the creditor was placing re-
liance upon the debtor’s ultimate ability to pay and
was not demanding immediate payment. This clearly
amounts to an extension of credit. When able to meet
its obligations by reasonable use of credit a debtor is
not insolvent. United States y. Anderson Co., supra;
Coffman v. Publishing Co., 167 Md. 275, 173 Atl. 248;
Long v. Republic Variish Enamel &c., Co., 115 N. J.
Eq. 212, 169 Atl. 860. Since the taxpayer was neither
insolvent, in the sense of an excess of liabulties over
assets, nor insolvent, in the sense that it could not meet
its current obligations, it was not within the terms of
the exemption.

A’s an alternative and additional argument, it 1s sub-
mitted that the taxpayer did not come within the ex-
emption since the receivership intended by this section
was obviously intended to mean one caused by financial
difficulties and not one arising from disputes between
the stockholders, charges of mismanagement, failure
to obey the laws, ete. As shown by the Committee Re-
ports on this bill, the intent of Congress was to exempt
those corporations in a weak financial condition.* In

* Adequate safeguards are provided in the bill to prevent un-
reasonable taxation of incomes in the case of corporations in

distress or with inadequate earnings to take care of their im-

mediate needs. * * * HY. Rep. No, 2475. THh Cong., 2d Sess.,

10

the instant case the receivership had no connection with
the financial condition of the taxpayer; it arose out of
a suit against a stockholder by his judgment creditor
and the subsequent officers of the company. (R. 25.)
In order for a company to use this exemption, it must
be in receivership as well as insolvent. Cooperative
Pub. Co. v. Commissioner, 115 F. (2d) 1017 (C. C. A.
9th).
II

The taxpayer was not entitled to either of the credits granted
in Section 26 (c) (1) or 26 (ce) (2)

The theory of the taxpayer’s case is that by giving
the mortgage note for $175,000 and assigning the lease
to the creditor it became entitled to the credit allowed
under Section 26 (ce) (1) or (2). It is well settled that
a eredit provision in the tax law should be as strictly
construed as an exempting provision. Helvering v.
Northwest Steel Mills, 311 U.S. 46; Helvering v. Inter-
Mountain Insurance Co., 294 U.S. 686; Crane-Johnson
Co. v. Commissioner, 105 F. (2d) 740 (C. C. A. 8th),
affirmed, 311 U. 8.54. The Northwest Steel Mills case
is directly contrary to the taxpayer’s contention that
Section 26 (c) is to be liberally construed. There the
Court stated (p. 49):

* * * Congress indicated that any ex-
empted prohibition against dividend payments
must be expressly written in the executed con-
tract. * * * the granted credit can only

p. 4 (1939-1 Cum. Bull. (Part 2) 667, 669). To the same effect
is S. Rep. No. 2156, 74th Cong., 2d Sess., p. 14 (1939-1 Cum. Bull.
(Part 2), Gre),

ill

result from a provision which ‘‘expressly deals
with the payment of dividends.”’
There was nothing in the mortgage, nor insofar as the
record reveals in the assigninent, that ‘‘expressly deals
with the payment of dividends.’’ Hence, Section
26 (c) (1) clearly does not apply.

It matters not what was the effect of the state law
concerning the mortgage and assignment, since it is
well settled that statutes specifically prohibiting divi-
dend payments do not constitute written contract ex-
ecuted by the corporation prohibiting such payments
within the meaning of Section 26 (¢) (1). Helvering
v. Northwest Steel Mills, supra; Utah Hotel Co. v.
Hinckley, 115 F. (2d) 920 (C. C. A. 10th); Bastian
wFos. Co. v. McGowap, 113 F. (2d) 489 (C. C. A. 2d),
certiorari denied, 311 U. 8. 702; and Cooperative Pub.
Co. v. Commissioner, supra. The whole theory of these
authorities is that although the corporation might not
be able to declare dividends because of the effect of
some superior force upon it, the credit was not allow-
able except when there was a written contract executed
by the corporation dealing expressly and not impliedly
with the question.

Similar principles apply in determining whether a
credit is allowable under Section 26 (c) (2). In order
to be entitled to a credit under that section the corpo-
ration must have executed prior to May 1, 1936, a writ-
ten contract containing a specific provision requiring
a portion of its earnings and profits of the taxable year
to be paid or set aside in discharge of a debt. There is
no such contract here.

2

Any promise to make periodic payments on an indebt-
edness would naturally be restrictive as to the earnings
and profits of the debtor but it can hardly be contended
that Congress meant to include within this section all
promises to liquidate just debts. It was intended that
the exemption apply only when an explicit contract re-
quired it to apply specifically a portion of its earnings
for the current year to the payment of a debt. Here
the royalties from the lease were paid directly to the
taxpayer and the taxpayer concedes that it was prop-
erly required to report the royalties as its income. (Br.
20.) Although the creditor might, by virtue of the
state law, be entitled to demand them from the tax-
payer, it is the force of the state law which gives him
this right and not an express contract dealing with the
disposition of the earnings and profits. See Helvering
v. Northwest Steel Mills, supra. The income from the
lease was assigned as security for the loan. (R. 24.)
If the taxpayer chose to pay the creditor from other
sources he would not care from what source he were
paid. Clearly this assignment as security was not an
express contract requiring the debtor to pay or irre-
vocably set aside a portion of the earnings during the
taxable year.

If the taxpayer’s theory were applied literally, it
would follow that all payments on account of legally
owing debts would constitute a credit against this tax,
since any payment on a debt will have a restrictive
effect on the company’s profits. It is a rare corpora-
tion that is not making payments on borrowed capital.
But Congress has not provided relief in such cases. It

13

has stated with meticulous care the eireumstances un-
der which a credit would be allowed. ‘The allowance of
eredits and deductions is within the discretion of Con-
eress and the language of the statute cannot be stretched
to cover this case because of any alleged hardship on the
taxpayer. See Helvering v. Northwest Steel Mills,
supra.

Moreover, the hardship here is more imaginary than
real, This corporation was a profitable going concern
during the year in question and should not escape this
tax merely because durmg those years it repaid a large
amount of its indebtedness. If there could be any un-
fairness im the mstant case, it would be the unfairness
to other corporations which paid this tax while making
a profit although not in a sound enough financial con-
dition to repay their capital investments.

CONCLUSION

The decision of the Board that the taxpayer was not
exempt and was not entitled to a credit for the amounts
paid was correct and should be affirmed.

Respectfully submitted.

SAMUEL O. CLARK, Jr.,
Assistant Altorney General.
Hrten RR. Caross,
SHERLEY JWINa,

Special Assistants to the Attorney General.

Avaust, 1941.

APPENDIX
Revenue Act of 1936, ¢. 690, 49 Stat. 1648:

sec. 14. SurTAx ON UNDISTRIBUTED PROFITS.
* * * %& *

(b) Imposition of Tax.—There shall be levied,
collected, and paid for each taxable year upon
the net income of every corporation a surtax
equal to the sum of the following, subject to the
applieation of the specific credit as provided in
subsection (¢):

7 per centum of the portion of the undis-
tributed net income which is not in excess of 10
per centum of the adjusted net income.

* ¥* * a %

(d) Hremption From Surtax.—The following
corporations shall not be subject to the surtax
imposed by this section:

* * ae ee *

(2) Domestic corporations which for any por-
tion of the taxable year are in bankruptcy under
the laws of the United States, or are insolvent
and in receivership in any court of the United
States or of any State, Territory, or the District
of Columbia.

%* * * * %

Sec. 26. CREDITS OF CORPORATIONS.

In the case of a corporation the following
credits shall be allowed to the extent provided in
the various sections imposing tax—

¥ oe ae * *
(ec) Contracts Restricting Payment of Divi-
dends.—

(1) PROHIBITION ON PAYMENT OF DIVIDENDS.—
An amount equal to the excess of the adjusted
net mcome over the aggregate of the amounts

(1)

15

which can be distributed within the taxable year
as dividends without violating a provision of a
written contract executed by the corporation
prior to May 1, 1936, which provision expressly
deals with the payment of dividends. If a cor-
poration would be entitled to a credit under this
paragraph because of a contract provision and
also to one or more credits because of other con-
tract provisions, only the largest of such credits
shall be allowed, and for such purpose if two or
more credits are equal in amount only one shall
be taken into account.

(2) Dtspostrion or Prorrrs oF TAXABLE
YEAR.—An amount equal to the portion of the
earnings and profits of the taxable year which is
required (by a provision of a written contract
executed by the corporation prior to May 1, 1936,
which provision expressly deals with the disposi-
tion of earnme'’s and profits of the taxable year)
to be paid within the taxable year in discharge of
a debt, or to be irrevocably set aside within the
taxable year for the discharge of a debt; to the
extent that such amount has been so paid or set
aside. For the purposes of this paragraph, a
requirement to pay or set aside an amount equal
to a percentage of earnings and profits shall be
considered a requirement to pay or set aside such
percentage of earnings and profits. As used in
this paragraph, the word ‘‘debt’’ does not include
a debt incurred after April 30, 1936.

* x ay * *

Treasury Regulations 94, promulgated under the Rev-
enue Act of 1936:

Art. 14-1. Surtax on undistributed profits of
cor porations.—
% % * * oS

A domestic corporation is not subject to the
surtax on undistributed profits if for any portion
of its taxable year—

(1) it is in bankruptcy under the laws of the
United States; or

16

(2) it is insolvent and in receivership in any
court of the United States or any State, Terri-
tory, or the District of Columbia.

* % oe % %

Art. 26-2. Credit in connection with contracts
restricting payment of dividends—(a) The
eredit provided in section 26 (¢) with respect to
contracts restricting the payment of dividends
is not available under every contract which might
operate to restrict the payment of dividends, but
only with respect to those provisions of written
contracts executed by the corporation prior to
May 1, 1936, which satisfy the conditions pre-
scribed in the Act. The charter of a corpora-
tion does not constitute a written contract exe-
cuted by the corporation within the meaning of
section 26 (ce). The provisions recognized by
the Act are of two general types, as folows:

(1) Those which come within section 26 (¢)
(1), in that they prohibit or hmit the payment of
dividends during the taxable year; and

(2) Those which come within section 26 (¢)
(2), in that they require the payment, or irrev-
ocable setting aside, within the taxable year, of
a specified portion of the earnings or profits of
the taxable year for the discharge of a debt 1n-
curred on or before April 30, 1936.

% % % % *

(b) Prohibition on payment of dividends—
The credit provided in section 26 (ce) (1) is al-
lowable only with respect to a written contract
executed by the corporation prior to May 1, 1936,
which expressly deals with the payment of divi-
dends and operates as a legal restriction upon the
corporation as to the amounts which it can dis-
tribute within the taxable year as dividends. If
an amount can be distributed within the taxable
year as a dividend—

(1) in one form (as, for example, in stock or
bonds of the corporation) without violating the

eh

provisions of a contract, but can not be dis-
tributed within the taxable year as a dividend m
another form (as, for example, in cash) without
violating such provisions, or

(2) at one time (as, for example, during the
last half of the taxable year) without violating
the provisions of a contract, but can not be dis-
tributed as a dividend at another time within the
taxable year (as, for example, during the first
half of the taxable year) without violating such
provisioi—
then the amount is one which, under section 26
(c) (1), ean be distributed within the taxable
year as a dividend without violating such
provisions.

The credit provided in section 26 (c) (1) is
equal to the excess of the adjusted net income, as
defined in section 14 (a), over the aggregate of
the amounts which can be distributed within the
taxable year without violating the provisions of
such contract. The requirement that the pro-
visions of the contract expressly deal with the
payment of dividends is not met in ease (1) a
corporation is merely required to set aside peri-
odically a sum to retire its bonds, or (2) the con-
tract merely provides that while its bonds are
outstanding the current assets shall not be
reduced below a specified amount.

= * * # *

(c) Disposition of profits of taxable year.—
Under the provisions of section 26 (ce) (2), a cor-
poration 1s allowed a credit in an amount equal
to that portion of the earnings and profits of
the taxable year which, by the terms of a written
contract executed by the corporation prior to
May 1, 1936, and expressly dealing with the dis-
position of the earnings and profits of the tax-
able year, it is required within the taxable year
to pay in, or irrevocably to set aside for, the dis-
charge of a debt incurred on or before April 30,
1936. The credit is limited to that amount

18

which is actually so paid or irrevocably set aside
during the taxable year pursuant to the require-
ments of such a contract.

Only a contractual provision which expressly
deals with the disposition of the earnings and
profits of the taxable year shall be recognized as
a basis for the eredit provided in section
26 (c) (2). A corporation having outstanding
bonds is not entitled to a credit under a provision
merely requiring it, for example, (1) to retire
annually a certain percentage or amount of such
bonds, (2) to maintain a sinking fund sufficient
to retire all or a certain percentage of such bonds
by maturity, (3) to pay into a sinking fund for
the retirement of such bonds a specified amount
per thousand feet of timber eut or per ton of
coal mined, or (4) to pay into a sinking fund for
the retirement of such bonds an amount equal
to a certain percentage of gross sales or gross
income. Such provisions do not expressly deal
with the disposition of earnings and profits of
the taxable year. A contractual provision, how-
ever, shall not be considered as not expressly
dealing with the disposition of earnings and
profits of the taxable year merely because it
deals with such earnings and profits in terms of
‘net income,’’ ‘‘net earnings,’’ or “‘net profits.’’

U.S GOVERNMENT PRINTING OFFICE: 1941